At Smead Capital Management, we have always said that the next best thing to being smart is knowing who is. As contrary investors, we’ve think we have pegged the three most contentious beliefs we carry into the stock market today. We believe that oil and commodities have peaked in price and will be in a secular bear market for ten years. Second, we believe that Chinese real estate development loan losses will cause huge balance sheet write downs for the four large government-owned Chinese banks. The need to re-capitalize these banks will cause a major credit contraction in China and cause the first meaningful economic recession/depression since they became a quasi-capitalistic economy. Lastly, we believe that the psychology surrounding the US economy associated with both the consumer and housing is overly pessimistic. As we look out to the last quarter of 2011, we will consider the thoughts of some very smart people to back up our belief.

Daniel Yergin wrote a Pulitzer Prize winning book twenty-plus years ago called, “The Prize”. It was history of the oil business from 1855 to 1990. Through the eyes of people who lived in each era, he told the story of oil. His book included how every 20 to 30 years, beginning in the late 1800’s, folks worried about us running out of oil. Recently, he was interviewed by the Wall Street Journal about his new book, “The Quest: Energy, Security and the Remaking of the Modern World”. In the interview, he disputed “Peak Oil” Theory and pointed out how similar today’s arguments are to the misplaced arguments of the last 120 years. Here is how he explained this to the Wall Street Journal:

“This is actually the fifth time in modern history that we've seen widespread fear that the world was running out of oil. The first was in the 1880s, when production was concentrated in Pennsylvania and it was said that no oil would be found west of the Mississippi. Then oil was found in Texas and Oklahoma. Similar fears emerged after the two world wars. And in the 1970s, it was said that the world was going to fall off the "oil mountain." But since 1978, world oil output has increased by 30%.

Just in the years 2007 to 2009, for every barrel of oil produced in the world, 1.6 barrels of new reserves were added. And other developments—from more efficient cars and advances in batteries, to shale gas and wind power—have provided reasons for greater confidence in our energy resiliency. Yet the fear of peak oil maintains its powerful grip.”

Oil is the largest component of and a dictating factor in the major commodity indexes. Another very smart person, Barry Bannister, the head of research at Stifel Nicolaus, explains in great detail how the pendulum swings back and forth over the decades between hard assets (primarily commodities) and paper assets (primarily stocks). His chart showing 10-year rolling returns on commodities in the US over 205 years is below:

 

Source: “World Energy Price, Economic Growth, and the Financial Setting of Agri-Business” By Stifel Nicolaus on March 9, 2011

Commodities have never done better in any 10-year stretch in the history of the US and, as the chart below shows stocks, coincidentally, have rarely done worse.

 
Source: “World Energy Price, Economic Growth, and the Financial Setting of Agri-Business” By Stifel Nicolaus on March 9, 2011

If you expect that commodity prices will decline over the next ten years, you have to believe that the country whose use of commodities has grown the most the prior five to ten years could see an interruption in their seemingly insatiable demand. To understand this we go to another very smart person, Cheng Siwei, head of Beijing's International Finance Forum and a former deputy speaker of the People's Congress. In an interview with the “Telegraph” in London, Cheng said this:

“Interest rate rises and credit curbs to cool overheating were inflicting real pain on thousands of companies used by local party bosses to fund the construction boom.

The tightening policy is creating a lot of difficulties for local governments trying to repay debt, and is causing defaults," he told a meeting at the World Economic Forum in Dalian. "Our version of subprime in the US is lending to local authorities and the government is taking this very seriously."

Cheng went on to say that China is entering a “very tough period” in their economy as they choose to fight inflation at the expense of an economic slowdown.

Next we needed to get our arms around the importance psychology is playing in the over-confidence placed by capital markets in the un-interrupted growth in the Chinese economy and the near total lack of confidence in the US economy. For that information and those thoughts we went to Edward Chancellor of Grantham, Mayo and Van Otterloo (GMO). In a recent piece, he explained the psychology and factors surrounding long-term swings in enthusiasm for the purchase of residences. This is done under the assumption that housing is a powerful driver of economic activity. First, he helps you understand this arena generically with this look at the history of real estate cycles:

Conclusion: The Real Estate Cycle in Five Easy Stages

1. Improvement. Demographic demand leads to rising rents. Vacancies fall. New housing supply is constrained. Home prices are affordable. Credit is available, but mortgage underwriting is relatively strict and leverage discouraged. Real estate is not the most favored asset class. Housing is seen as a necessity rather than an exciting investment.
2. Growing Confidence and Prosperity. Home prices rise above trend. New housing supply fails to keep up with demand. Rising collateral values support greater issuance of mortgages. Property is seen as a sound investment.
3. Excitement and Overtrading. Home prices rise to two standard deviations or more above trend. Rental yields approach record lows. New housing supply exceeds fundamental demand. Spurious demographic arguments justify still more construction. The macro-economy becomes increasingly dependent on the real estate market as rising home prices spur consumption and building activity provides jobs. Mortgage growth remains strong despite rising interest rates. New financial instruments improve affordability. Despite elevated valuations and excess supply, real estate is seen as the most attractive asset class. Speculators increasingly dominate the market.
4. Convulsion, Pressure, Stagnation and Distress. The higher cost of mortgages and/or the restrictions on property lending induce a downturn. Losses appear on real estate loans. Home prices fall and rental yields rise. Housing transactions dry up, vacancies increase, and new construction dips sharply. The downturn in the housing market hurts the wider economy. Household formation and the rate of homeownership experience a cyclical contraction. Despite falling interest rates, credit conditions remain tight. Banks foreclose on delinquent mortgage loans. A rising number of homeowners experience negative equity. The general attitude toward real estate is one of panic and scapegoating.
5. Quiescence. House prices have fallen below their long-term trend. Fundamental demand for housing pushes up rents. Excess supply during the boom has been offset by insufficient construction during the downturn. Employment conditions stabilize. Mortgage credit is available, but lenders remain conservative. Leverage is eschewed. Despite improved affordability and sound demographic underpinnings, spurious arguments are made against the prospect of a recovery. Property is seen as an illiquid and unattractive asset class. As the “error of pessimism” waxes, the real estate cycle approaches its trough.

Based on this intensive study, Chancellor concluded that China’s economy, with its dependence on real estate construction, is headed for big trouble:
 

“Chinese real estate merits attention. After all, property construction accounts for some 13% of GDP in the world’s second largest economy. Construction has been one of the most important drivers of economic growth.36 Some 14% of China’s workforce is employed in the building trade. Construction also provides the largest market for steel and other heavy industries. Residential development is closely tied up with Chinese infrastructure, which since 2009 has constituted the bulk of fixed asset investment. Economist Stephen Green of Standard Chartered suggests that around 50% of China’s GDP is linked to the fate of the property market.”

He goes on to say:

“Chinese real estate casts a long shadow over the global economy. China is the world’s largest consumer of steel and cement and dominates a number of other commodity markets, most notably copper. China has replaced the United States as the largest contributor to global economic growth. This contribution has depended ultimately on China’s booming real estate market. It’s no exaggeration to say that Chinese property has become the ‘most important sector in the universe."

Lastly, Chancellor compares China’s real estate bubble to past similar bubbles in the following chart: 



In an even more contrary way, Chancellor makes the case that the US housing market is subject to what he calls the “Error of Pessimism”. Here is his list of reasons to believe that the positive side of the real estate cycle could be upon us in the US and housing could actually begin to contribute to the US economy going forward: A Trough in the Real Estate Cycle?

• The healing passage of time. Five years have passed since U.S. housing prices peaked. That’s about the average amount of time it has taken for real estate markets to trough after previous housing bubbles. Deleveraging by households may continue for some time to come, but this doesn’t preclude a recovery in the housing market.
• Valuations are no longer over-stretched. The home price to income ratio is around one standard deviation below its trend. Rental yields have also recovered. For the first time since 1981, median monthly mortgage payments are lower than rents.32 Following the decline in long-term interest rates, owning a home has become much more affordable. The National Association of Realtors’ affordability index is at an all-time high.33 This is one of the best times ever for Americans to buy a home.
• Speculators replaced by investors. At the bottom of the cycle assets typically move from weak hands to strong hands. The share of speculative purchases financed with mortgages has come crashing down since the 2005 peak. Conversely, the number of cash transactions (an investor proxy) in June rose to 29% of total existing home sales.34
• Credit crunch is over. Although delinquencies on mortgages remain high, one should not exaggerate the tightness of the mortgage market. The number of foreclosures has turned down over the last year. The latest Fed loan officers’ survey suggests that credit conditions are loosening. The demand for residential mortgages may still be falling, but lenders are not expecting this decline to continue. Subprime mortgages are no longer available, but more than 80% of requests for new mortgages are approved.
• End to Deflation. The Fed has kept short-term rates at zero for three and a half years. Ben Bernanke has shown a grim determination to ward off deflation. We have experienced successive bouts of quantitative easing, with more to come if necessary. In the year to July 2011, the U.S. consumer price index climbed 3.6%.
• Overhang of excess housing supply has diminished. During the bubble, housing starts were far above average. But this overbuilding has been offset by several years of below average housing starts. Single family housing starts are running at less than half their long-term trend. The overhang on the housing market resulting from excessive construction in the bubble years has thus largely disappeared
• Housing glut exaggerated. The supply of houses for sale remains very elevated relative to current demand. But, then, homes sales have fallen to a 30-year low. If demand were to recover to normal levels, then today’s excess supply would evaporate to be replaced by a shortage (see Exhibit 11).
• Pent-up demographic demand. The long-term fundamentals for the U.S. housing market are sound. The population is forecast to grow by around 10% over the current decade, which is only a little below average. Household formation has fallen to 40-year lows in the aftermath of the global financial crisis (see Exhibit 12). Around half of recent college graduates are reported to be living with their parents. The homeownership rate has fallen back from its bubble peak and returned to the level found at the turn of the century. Rents have been increasing. All of this suggests there is a rising pent-up demand for housing.
• Extreme Pessimism. Last September, a Time magazine cover story suggested it was time to “re-think homeownership.” There has even been talk of a “new paradigm” for U.S. housing with the claim that household formation will not regain its long-term trend and that renting will be permanently preferred to homeownership. The American dream is over.

The last smart person we’d reference is Federal Reserve Chairman Ben Bernanke. We believe he understands that commodities will come down in price; that housing will make a comeback in the next couple of years; and that US households have done a great job preparing their income statements for future prosperity. US Households are doing remarkable and historical work of getting their finances in order. The Household Debt Service Ratio dropped to 11.09% at the end of June after being as high as 14% in late 2007. This is the ratio of how much of the average family’s gross income is dedicated to debt service. The statistics are reported on a 90-day lag, which means that the ratio is probably below 11% by now. At the pace that households are improving their income statements, we could see a ratio of 10.6% in the next year. Numbers below 11% existed in 1982 and 1992 at the beginning of extended periods of prosperity. What this means is that households could take on monthly payments comfortably and that bodes well for the employment rich automobile and housing industries.

Here is how we are putting this all together as portfolio managers. These smart folks have helped us to think straight about the following. We are avoiding capital-intensive, cyclical businesses that have seen prosperity which originates in the boom caused by China’s un-interrupted growth. We are avoiding anything commodity-related and countries which have benefitted from the boom in natural resources.

On the positive side, we are very excited about how cheap and attractive our domestically- dominated companies are. In our opinion, it is obvious how much non-cyclical, domestically oriented stocks have been neglected these last ten years as investors preferred “hard assets” over “paper assets”. We believe and expect the most prosperous activity in the world the next five years will be meeting “pent up demand” from US consumers who will come out of the woodwork when confidence rises. We expect home buyers in the US to be rewarded for their courage as the cycle turns. Lastly, we expect the catalyst for that improvement in confidence will come from dramatically lower prices paid for oil and other key commodities.

Thank you for your ongoing confidence and trust in our portfolio management services.